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Author: Xiao Yanyan, Jin Shi Data
Although the market seems to have taken another interest rate cut by the Federal Reserve as a foregone conclusion and pushed U.S. stocks close to record highs last Friday, the outcome of this week’s Federal Reserve policy meeting is not good for the bull market in stocks and other risk assets.The real driver may not come from interest rates.
“For now, the interest rate side of monetary policy is certainly restrictive, but that doesn’t seem to matter,” said Michael Kelly, global head of multi-asset at PineBridge Investments, a global investment firm with $215.1 billion in assets under management.
At least that’s judging by the performance of the S&P 500.According to Dow Jones Market Data, the index was up 16.8% for the year as of Friday, and is expected to usher in another outstanding year.
According to Kelly,There are actually two monetary policies at work in the United States.One is a balance sheet monetary policy for the “asset-rich” class, which continues to enhance the “wealth effect”, stimulate consumption and support the economy; the other is an interest rate policy for everyone else.
Kelly noted that high interest rates are already hurting small businesses that are laying off workers.In the K-shaped economy, lower-class families are also under pressure, while the situation of upper-class families can be said to have improved.
Recent credit card data tells a similar story.Grace Zwemmer, an associate economist at Oxford Economics, wrote in a report on Friday that low-income consumers more often carry credit card debt and are more likely to hit their credit limit.But consumer spending is being driven by higher-income consumers who have less need to carry credit card debt.
Kelly believes thatThese two economic realities make anything the Fed says about its $6.5 trillion balance sheet critical to markets.“Are they going to keep their balance sheet the same size or start expanding again?”
Despite partial weakness during a tumultuous year during Trump’s second term, U.S. stocks appear poised to regain all-time highs soon.
Over the past three years, the S&P 500 has gained an astonishing 73%, according to FactSet.
The boom stems both from the market’s enthusiasm for the topic of artificial intelligence and reflects the fact that the Federal Reserve’s high interest rates have done little to dampen bullish sentiment in the stock market.
Equally important, credit spreads remain near record lows, suggesting investors are not too worried about looming default risks.
Possible Fed Actions
This favorable asset backdrop comes after the Federal Reserve has reduced its peak balance sheet during the epidemic of about $9 trillion by about $2.5 trillion.Subsequently, the Fed stopped shrinking its balance sheet on December 1 after stress emerged in overnight funding markets.
This is important because the Fed has repeatedly stated publicly that it wants to avoid a repeat of the 2019 repo crisis.Bank of America Global’s interest rate strategy team said on Friday,They expect the Fed to announce this week that it will purchase Treasury bills with maturities of one year or less starting in January at a monthly rate of $45 billion as a “reserve management operation.”
This will result in the Fed buying at least $20 billion in bonds per month to support natural balance sheet growth, and an additional $25 billion in bonds to reverse excessive reserves losses, at least for the first six months, the report said.
Others believe it may take more time and that the Fed won’t need to do much to keep markets running smoothly.
“From a broader perspective, the Fed will naturally start buying Treasury bills next year as part of its reserve management operations, because as the economy’s demand for reserves expands, the Fed will naturally meet it,” said Roger Hallam, global head of rates at Vanguard Fixed Income Group.
Hallam expects the Fed to begin buying Treasury securities at a rate of $15 billion to $20 billion per month by the end of the first quarter or early in the second quarter of next year.
“This is a normal central bank reserve operation that does not contain a monetary policy signal. This is just a normal course of business that the Fed should do to ensure liquidity in the system. This is to keep funding rates stable,” he said.
PineBridge’s Kelly expects the Fed to cut interest rates by another 25 basis points on Dec. 10, which would bring the policy rate to a range of 3.5%-3.75%, one step closer to the historically neutral rate of about 3% aimed at keeping the economy running smoothly.
Still, yields on longer-dated U.S. Treasuries rose sharply over the past week despite expectations for an imminent rate cut.The 10-year Treasury yield hit 4.14%, signaling that borrowing costs for households, businesses and the U.S. government are likely to remain high even as short-term interest rates fall.
Kelly said he was “fairly optimistic” about most markets next year, even if the central bank only talked about starting to expand its balance sheet in the new year to return to a more “normal liquidity” background.
“I don’t understand why the Fed is so active in expanding its balance sheet but so stingy in cutting interest rates. If it were me, I would take the opposite approach,” Kelly said.
